Igor Mazilin, the founder and CEO of INGVARR, prepared an op-ed for DeCenter on the most burning issues of blockchain assets regulation in 2019.
In 2017 and 2018, the number of legal cases related to blockchain assets increased dramatically, mainly in the United States. These litigations are of a different nature and include corporate disputes (R3 versus Ripple), claims of clients versus service provider companies (the U.S. versus Coinbase), actions of regulatory bodies in court (the SEC versus AriseBank), and others. The overwhelming majority of cases are related to allegations of fraud or claims for unregistered offers of securities made by supervisory authorities or individuals who participated in initial coin offerings (ICO). The critical legal question in such disputes is whether the token is considered a security by the law of the country where the company attracting the funds is located or by the law of the state where the person participating in the offering resides.
Tokens, in most cases, are classified according to:
Means of creation;
Today, from the law perspective, it would be correct to divide blockchain assets into two main categories: security tokens and all other tokens. This is because the key differences in the legal regime for the existence of these objects are in this area. Tokens can be classified into different types within these generic concepts. When we talk about security tokens, we mean securities issued using the blockchain technology. But is a security token a new legal object for which specific regulation needs to be developed?
If we turn to history, the security, as a legal object, emerged as a way of securing a certain number of rights on a certain carrier in order to simplify the transfer of such rights between the participants of civil turnover. With the advent of computers, the storage medium has become electronic. Now all the securities that are in circulation on the public market exist in electronic form and are recorded by the registrars and depositaries. Blockchain technology is just a new way of securing rights to a security in electronic form. In theory, this is a more efficient way than current centralized accounting. Thus, a security token is not a new legal object, which is somehow different from an ordinary security, but a new way of accounting for such rights.
Different jurisdictions have different views on the term “security.” The approach to the definition of what exactly is a security in the whole world (Europe, Russia, Asia) is more formal and is based on reading the corresponding definition in the relevant legislative act of the respective country. The list, as a rule, includes a share, a bond, another debt instrument, a certificate of ownership of shares in the fund, and so on. That is, everything that does not fall under this definition is not formally a security from the law perspective. The U.S. SEC broadly interprets the term “security” and looks not only at the lists of instruments specified in U.S. securities legislation but also draws attention, first of all, to what particular rights such securities provide to their holders. For example, in the release issued in mid-2017, the SEC analyzed in some detail the fact that tokens can be recognized as an investment contract, that is, a tool in accordance with which their owners invest money in certain enterprises for the purpose of making a profit and do not accept participation in enterprise management. Hence the key thesis of the crypto industry 2017–2018–structure the token in such a way that it is not a security, and sell it as you wish everywhere except the United States and countries where the sale of tokens is prohibited. The phrase “so that it is not a security” just means the requirement that the token does not consolidate the rights usually associated with the rights to such securities as stocks and bonds.
In general, the concept of financing for utility tokens has grown out of the crowdfunding industry of startups through prepaid products that are still being created. It was all well-known before the appearance of the ICOs, but there were other amounts of funding. The 2017–2018 ICO brought funding for the promise of future products or services to a completely different level, and this should be alarming. But the key here is not this, as the acquisition of a still uncreated product, for example, on Kickstarter, does not imply the creation of a secondary market for this product before its appearance. In 2017 and 2018, the overwhelming majority of projects initially understood that the success of raising money for the realization of their ideas was possible only with the promise of a secondary market. The presence of a highly-liquid secondary market for an empty—from the functionality side—utility token raises a big question about the correctness of the thesis that since such a token formally does not fall under the definition of securities, you can do anything with such an investment and special regulation should not be applied. The correctness of this thesis is still subject to verification.
The issuance of security tokens is not an improved version of ICOs. Rather, it is a traditional method of raising capital presented in the digital format under securities market legislation. From the law perspective, the issuance and circulation of such instruments are subject to the same rules as the issuance of traditional securities. That is why the largest and most well-known tokens on the market structured the supply of tokens according to the rules governing the global offering of securities. The blockchain ecosystem is a combination of a number of elements that together ensure the implementation of a whole range of actions, from creating tokens to trading digital securities. Issuing tokens, complying with legal requirements, storing, carrying out subsequent transactions, and realizing rights for such tokens are relationships that can be automated in many aspects. Blockchain provides an exciting opportunity through the use of smart contracts. The release of securities as tokens theoretically allows automating the fulfillment by the issuer of its obligations (for example, to automate voting or dividend payments), which certainly provides very interesting and attractive opportunities.
The accounting for rights to securities and fixing the transfer of the rights in many jurisdictions should be carried out following certain rules, often with the involvement of special professional intermediaries (registrars, depositories, custodians). In this sense, blockchain-powered rights accounting may contradict the law.
The main problem is that different countries have different systems of law and use different approaches to their accounting. In many states with a continental law system (for example, Germany), there are strict requirements regarding the registration of rights to securities of private companies (the need to attract a notary, keeping a register in paper form, and so on). In other countries, such as Cyprus, there are no strict requirements as to where the registry is maintained. For the securities rights accounting system to work, changes will be required not only in the laws of countries with a continental law system but also in the laws of countries with a common law system.
At the moment, special regulation for recording rights to securities using the blockchain technology exists only in the U.S. state of Delaware and in France. The state of Delaware, in which most of the U.S. companies are registered and which has the most developed corporate legislation, approved a law in 2017 allowing the use of blockchain to record securities (rights accounting using a distributed ledger). In December 2018, a decree was passed in France effectively securing the possibility of using DLTs for registering securities, fixing the transfer of rights to them, and identifying the owner without the involvement of registrars, depositories, and custodians as intermediaries. There are similar bills in a number of jurisdictions, such as Luxembourg, the countries of the Baltic region, and Russia.
The recognition of the possibility of recording rights to securities using advanced technologies and systems, including the blockchain technology, at the legislative level is one of the prerequisites for the development of the security tokens market.